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Investment Overview for Bank of America (NYSE:BAC)

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Below are key drivers of Bank of America's value that present opportunities for upside or downside to the current Trefis price estimate for Bank of America:

Sales & Trading

Yield on FICC Trading Assets: Bank of America's trading yield has been around 5% in recent years, after recovering from lows of -4.6% in 2008 at the peak of the global economic crisis. While we estimate yield figures to be around 6% going forward, should the division see a worse-than-expected performance in coming years, the yield could decrease to 4% over the Trefis forecast period. If that were to occur there would an upside of 5% to the Trefis price estimate.

Investment Banking EBT Margin: Bank of America's investment banking business has reported margins of just under 30% in 2012 and 2013. We forecast an improvement in margins to around 40% in the years to come. However, if these margins remain around current levels over our forecast period, then there would be a downside of about 7% to the current price estimate.

Mortgages

Non-Interest Expenses as % of Mortgage Revenues: Bank of America's mortgage business has been the biggest source of concern for investors, as there are significant doubts regarding the quality of its mortgage portfolio. Bad mortgages, and settlements related thereto, have cost Bank of America billions of dollars in recent years. We capture this in our analysis by non-interest expenses as a percentage of the mortgage division's total revenues, and this figure has been as high as 200% between 2011 and 2013. While we expect the bank's mortgage-related expenses to reduce to about 50%, a slower decline could occur in which the figure remain around 80% revenues by the end of our forecast period. This would result in a 5% downside to the Trefis forecast price.

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Bank of America is one of the leading financial institutions in the U.S. and, along with JPMorgan Chase, is one of the two largest U.S. banks by total assets. Through its operations in the U.S. and certain international markets, the firm offers a range of products and services such as credit and debit cards, mortgages, auto loans, commercial loans, investment banking, wealth management and sales and trading.

Bank of America's clients range from individual consumers to multinational corporations, financial companies and governments. The firm makes a significant portion of its revenue from lending activities from which it earns a net interest spread. The bank also generates non-interest revenues such as investment banking advisory fees, asset management fees and yields on trading assets.

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Corporate and Commercial Banking is the most valuable division for Bank of America for the following reasons:

High Interest Yields in Corporate and Commercial Banking

In 2012, Bank of America's Corporate and Commercial Banking division had just under $300 billion of interest-earning business loans and about $200 billion of interest-earning treasury-client assets. We expect these figures to increase to around $400 billion and $300 billion respectively over our forecast period, and we expect that Bank of America will earn a net interest yield of around 3.5% on these assets.

In comparison, Bank of America's Wealth and Investment Management division had $2.17 trillion of assets under management in 2012, but was earning a fee representing just about 0.4% of these assets. Bank of America also had about $250 billion of private banking assets in 2012, primarily representing loans to private banking clients, which were earning an average net interest yield of about 2.3%. The notably higher yield for the Corporate and Commercial Banking division is why it is more valuable to the bank than Wealth Management.

As mentioned above, Bank of America had about $500 billion of total interest-earning assets in 2012 within its Corporate and Commercial banking business. In comparison, the company had outstanding credit card balances of just above $110 billion on which it earned an average net interest yield of 9% compared to the average net interest yield of 3.1% in the Corporate and Commercial Banking business.

In the mortgage business, Bank of America had mortgage loans of $122 billion in 2012 and earned an average net interest yield of 2.4% on them.

Higher Margins in Corporate and Commercial Banking due to Minimal Loss Allowances

Bank of America's high operating margins in the credit card and mortgage business declined precipitously from 2007 to 2009 due to higher allowances for loan losses as a consequence of the financial crises. Provisions within the credit card business increased from 5% in 2006 to cross 15% in 2009, while those in the mortgage business went from 0.1% in 2006 to 13% in 2011. We expect loan losses allowances to decrease and margins to gradually improve in both businesses.

In comparison, Bank of America's margins within Corporate and Commercial Banking have fared much better. After declining from 57% in 2005 to about 18% in 2009, margins recovered to almost 52% in 2011 before settling at 48% in 2012. We expect margins within Corporate and Commercial Banking to remain much higher than those within the credit card and mortgage businesses.

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The entire banking industry has come under a lot of pressure in the wake of the financial crisis of 2008-10. Rising delinquencies in consumer loans, credit card and mortgages have strained the industry's revenue base and profits. We believe certain key trends will play out in the banking industry going forward:

Regulatory reforms expected to pressure revenue growth going forward

Increased regulation facing the financial services industry is likely to reduce the top line for most financial institutions. In the past, lighter regulation allowed for greater risk-taking for many parts of the businesses, which drove strong earnings. Analysts at Goldman Sachs have said that new regulations could cut bank earnings by nearly 13%, with larger banks such as Bank of America and Citigroup expected to lose an even greater portion of their earnings power moving forward. Regulation is expected to affect the banking industry in several ways:

Banks will be required to hold additional capital reserves which will slow down lending growth

The CARD Act passed by Congress is expected to reduce income by prohibiting issuers from raising rates, fees and finance charges on existing balances or on prospective accounts in the first year

The Volcker rule has led many banks to spin off their proprietary trading businesses

Securitization will become less appealing as investors and regulators will demand that banks now retain some risk

Consolidation expected to continue

As a result of the financial crisis, the banking industry saw a period of mergers and consolidation. The industry continues to see consolidation in almost every aspect of the business as players try to globalize and increase scale. Customers are also becoming increasingly risk averse and turning to larger players with stronger deposit bases.

The acquisitions of Countrywide, Merrill Lynch and LaSalle have increased Bank of America’s Mortgage, Investment and Retail banking business. The addition of Merrill Lynch has resulted in the combination of Bank of America’s Premier Banking & Investments business to form Merrill Lynch Global Wealth Management. This addition has helped increase the number of financial advisers, assets under management and client brokerage assets.

Projected cost savings to drive substantial margin expansion

Acquisitions have also helped Bank of America achieve substantial cost savings. The Merrill Lynch deal alone is estimated to have cut costs by up to $7 billion through 2012. The ongoing Project New BAC should also result in net expense reductions of $5 billion per year for Bank of America by 2014. This will greatly improve operating margins moving forward for the firm.

We have valued Bank of America by applying a Dividend Discount Model in which we treat dividends to common shareholders as free cash flow to equity and discount dividends to the present at the company's estimated cost of equity.

In order to apply the Dividend Discount Model, we must determine what fraction of annual net income will or can be paid out as dividends or returned to shareholders in alternative ways such as share buybacks.

${forecast} represents the fraction of annual company-wide net income that could be returned to common shareholders in the form of actual dividends, potential dividends and share buybacks.

For additional details on the application of the Dividend Discount Model, please see our FAQ.

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Bank of America's ${forecast} was 82% in 2005, 114% in 2006 and 98% in 2007. Excluding share repurchases, the company's actual dividend payout ratio was 47% in 2005, 46% in 2006 and 73% in 2007.

We show a dividend payout ratio of 0% for Bank of America for 2008 and 2009 despite the fact that the company did pay dividends in those years.

In 2008, Bank of America had net income (available to common) of about $2.6 billion (down 83% from $14.8 billion in the prior year), on which it paid dividends of about $10 billion to common, implying a payout ratio of about 400% which is exceptionally high.

In 2009, Bank of America paid out about $4.5 billion of dividends to preferred shareholders after which it had net income (available to common) of about -$2.2 billion. The company paid out only about $330 million of dividends to common shareholders and repurchased about $3.8 billion of common stock. Bank of America's implied dividend payout ratio for common shareholders in 2009 was -15%, which is not representative of the company's payout over longer historical periods.

In 2010, Bank of America posted a net income of -3.6 billion and paid out dividends worth $405 million. This represents an implied dividend payout of -11%.

In 2011, Bank of America continued to payout a token dividend totaling $410 million even as net incomes were a mere $84 million. This represents an extraordinary implied dividend payout of 488%.

In 2012, Bank of America reported handed out $481 million in dividends to holders of common shares, which represents an implied payout of 17% for its $2.8 billion net income figure.

We estimate that Bank of America's ${forecast} will grow to reach 65% towards the end of the Trefis forecast period.

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Trefis considered the following factors for its forecast:

Maintenance of Capital Adequacy Ratios

We estimate that Bank of America will maintain a ratio of tangible common equity to earning assets of about 5% over our forecast period.

Return on Equity Increasing to Around 12% Over Forecast Period

We use our forecasts of Bank of America's businesses to calculate overall net income for Bank of America to which we apply our dividend payout ratio and use the remaining net income (not paid out as dividends) to grow the bank's equity base. Based on our calculation of future net income and shareholders equity, we calculate a return on equity for Bank of America of nearly 8% in 2013, increasing to 12% by the end of our forecast period.

How Does Trefis Modelling Work?

How do we get the historical numbers for this chart?

Trefis has a team of in-house Analysts who gather historical data from company filings and other verifiable sources. When historicals are available, we explain how we got them at the bottom of the Trefis analysis section below.

Who came up with the Trefis forecast for future years?

The Trefis team of in-house Analysts considers a variety of factors when projecting any forecast. The rationale for our projections is explained in the Trefis analysis section below.

How does my dragging the trendline on the chart impact the stock price?

We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.

We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.

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